25. THE FUNCTION OF A CASH RESERVE

BY IRVING FISHER

It cannot be too strongly emphasized that, in any balance sheet, the value of the liabilities rests on that of the assets. The deposits of a bank are no exception. We must not be misled by the fact that the cash assets may be less than the deposits. When the uninitiated first learn that the number of dollars which note-holders and depositors have the right to draw out of a bank exceeds the number of dollars in the bank, they are apt to jump to the conclusion that there is nothing behind the notes or deposit liabilities. Yet behind all these obligations there is always, in the case of a solvent bank, full value; if not actual dollars, at any rate dollars' worth of property. By no jugglery can the liabilities exceed the assets except in insolvency, and even in that case only nominally, for the true value of the liabilities ("bad debts") will only equal the true value of the assets behind them.

These assets are largely the notes of merchants, although, so far as the theory of banking is concerned, they might be any property whatever. If they consisted in the ownership of real estate or other wealth in “fee simple," so that the tangible wealth which property always represents were clearly evident, all mystery would disappear. But the effect would not be different. Instead of taking grain, machines, or steel ingots on deposit, in exchange for the sums lent, banks prefer to take interest-bearing notes of corporations and individuals who own, directly or indirectly, grain, machines, and steel ingots; and by the banking laws the banks are even compelled to take the notes instead of the ingots. The bank finds itself with liabilities which exceed its cash assets; but in either case the excess of liabilities is balanced by the possession of other assets than cash. These other assets of the bank are usually liabilities of business men. These liabilities are in turn supported by the assets of the business men. If we continue to follow up the ultimate basis of the bank's liabilities we shall find it in the visible tangible wealth of the world.

We have seen that the assets must be adequate to meet the liabilities. We now wish to point out that the form of the assets must be such as will insure meeting the liabilities promptly. Since the business of a bank is to furnish quickly available property (cash

'Adapted from The Purchasing Power of Money, pp. 40–46. (The Macmillan Co., 1913.)

or credit) in place of the "slower" property of its depositors, it fails of its purpose when it is caught with insufficient cash. Yet it "makes money" partly by tying up its quick property, i.e., lending it out where it is less accessible. Its problem in policy is to tie up enough to increase its property, but not to tie up so much as to get tied up itself. So far as anything has yet been said to the contrary, a bank might increase indefinitely its loans in relation to its cash or in relation to its capital. If this were so, deposit currency could be indefinitely inflated.

There are limits, however, imposed by prudence and sound economic policy on both these processes. Insolvency and insufficiency of cash must both be avoided. Insolvency is that condition which threatens when loans are extended with insufficient capital. Insufficiency of cash is that condition which threatens when loans are extended unduly relatively to cash. Insolvency is reached when assets no longer cover liabilities (to others than stockholders), so that the bank is unable to pay its debts. Insufficiency of cash is reached when, although the bank's total assets are fully equal to its liabilities, the actual cash on hand is insufficient to meet the needs of the instant, and the bank is unable to pay its debts on demand.

The less the ratio of the value of the stockholders' interests to the value of liabilities to others the greater is the risk of insolvency; the risk of insufficiency of cash is the greater the less the ratio of the cash to the demand liabilities. In other words, the leading safeguard against insolvency lies in a large capital and surplus, but the leading safeguard against insufficiency of cash lies in a large cash reserve. Insolvency proper may befall any business enterprise; insufficiency of cash relates especially to banks in their function of redeeming notes and deposits.

Since, then, insufficiency of cash is so troublesome a conditionso difficult to escape when it has arrived, and so difficult to forestall when it begins to approach-a bank must so regulate its loans and note issues as to keep on hand a sufficient cash reserve, and thus prevent insufficiency of cash from even threatening. It can regulate the reserve by alternately selling securities for cash and loaning cash on securities. The more the loans in proportion to the cash on hand the greater the profits, but the greater the danger also. In the long run a bank maintains its necessary reserve by means of adjusting the interest rate charged for loans. If it has few loans and a reserve large enough to support loans of much greater volume, it will endeavor

to extend its loans by lowering the rate of interest. If its loans are large and it fears too great demands on the reserve, it will restrict the loans by a high interest charge. Thus, by alternately raising and lowering interest, a bank keeps its loans within the sum which the reserve can support, but endeavors to keep them (for the sake of profit) as high as the reserve will support.

If the sums owed to individual depositors are large relatively to the total liabilities, the reserve should be proportionately large, since the action of a small number of depositors can deplete it rapidly. Similarly, the reserves should be larger against fluctuating deposits (as of stockbrokers) or those known to be temporary. The reserve in a large city of great bank activity needs to be greater in proportion to its demand liabilities than in a small town with infrequent banking transactions.

Experience dictates differently the average size of deposit accounts for different banks according to the general character and amount of their business. For every bank there is a normal ratio, and hence for a whole community there is also a normal ratio an average of the ratios for the different banks. No absolute numerical rule can be given.

any

B. Analysis of Bank Loans

(1) INTRODUCTORY

26. THE MANAGEMENT OF LOANS

In business the extent and character of the assets owned in relation to the liabilities is the test of good management. If the accounts and bills receivable are certain to be paid when due, and if they are ample to cover all current liabilities, the business is regarded as fundamentally sound. Commercial banking differs from other businesses in this connection only in the greater need imposed upon it of keeping its assets in a liquid form. If a merchant finds himself unable to meet current obligations from maturing assets, he may seek an extension of time, but a bank when called upon to discharge its obligations must pay at once. If it has insufficient funds for the purpose there are but two alternatives open: to secure a loan from another bank or to announce insolvency. The procuring of the necessary funds from other bankers is often impossible, and it is therefore of the greatest importance that a bank manage its loans and discounts in such a way that they may be absolutely relied upon.

The greatest care should be observed in the granting of loans. The security offered should be such that the bank has virtually no doubt of the safety of the loan and of its prompt payment. The maturities of the loans should be so arranged that they will insure, as nearly as may be, a constant flow of funds to the bank, a flow ordinarily sufficient to meet the constant drain of funds from the bank. A correct policy in this connection would endeavor to provide for as many maturities as possible on days or weeks that are known to be periods of heavy withdrawals, and to arrange for fewer payments when the withdrawals are known to be light. It is obviously impossible to make the flow of funds to the bank exactly coincide with the withdrawals so that no reserve at all would be required-but it is evident that the bank management should strive for this goal. The sounder and more liquid the loans that are made and the more scientific the arrangement of maturities, the less is the reserve required in the handling of a given quantity of business, and in consequence the greater margin of profit to the bank.

27. CLASSIFICATION OF LOANS IN NATIONAL BANKS'

The ordinary commercial bank has the option of making the following types of loans: first, on notes secured by mere personal responsibility; secondly, on notes secured by real estate; thirdly, on commercial paper of the following kinds: (a) the single-name promissory note, (b) indorsed notes and accepted drafts, (c) notes and drafts accompanied by documentary evidence; fourthly, on notes secured by collateral.

These loans may be further classified according to whether they are time loans thirty, sixty, or ninety days, or more or demand loans, subject to immediate liquidation.

The following table shows the classification of loans, first, in all national banks, and, secondly, in all national banks in New York City:

' Compiled from reports of the Comptroller of the Currency.